See the World (Differently)

This article originally appeared in the fall 2007 issue of Morningstar Advisor magazine. Subscribe today. We also value your comments. E-mail us with your viewpoints, ideas, and other feedback.

There's been little argument over the notion that investors should have some foreign exposure as part of their portfolios. Asset allocators and financial advisors have long recognized the benefits of buying international stocks and mutual funds. Indeed, it's been decades since Harry Markowitz, t he father of modern portfolio theory, introduced the idea of the efficient frontier, which suggested that an allocation (10% to 20% seemed to be the standard) to international stocks provided the optimal combination of risk and return.

Back then, though, the purported reasoning behind the inclusion of international stocks stemmed from the benefits of diversification. Overall, risk was lower because when U.S. markets were weak, foreign markets were stronger--or at least providing some ballast to investor portfolios. The fact that global markets behaved differently, over time, helped investors achieve better returns.

But times change, and the diversification argument is becoming harder to make. In today's global economy, borders are blurring, economies are connecting, and what country a company calls home doesn't necessarily say much about where it's making its money. As the world's markets move together, you and your clients may wonder: Is globalization weakening the case for international investing?

We believe the opposite is true. In today's world, more than ever, a healthy stake of international stocks should be an essential part of most people's portfolios. But the reasons for investing overseas are changing. To be sure, there are still diversification benefits to be had, especially in emerging markets and currencies. The better arguments for going abroad, however, are that many of the world's great investment opportunities are overseas and that is where many of today's top investors ply their trade.

Mimicking MarketsInvestors can no longer count on the conventional thinking that an international stake will automatically diversify their portfolio. Correlations between the S&P 500 Index and the MSCI EAFE Index are higher today than they were 20 years ago. And over the past five years, the typical foreign large-growth and large-value funds weren't any more volatile than their domestic counterparts, suggesting that investing overseas doesn't require investors to take on more risk than they would by investing domestically.

Also, markets tend to act more like each other in times of stress and excess--precisely when investors most need diversification. The correlation between the S&P 500 and the MSCI EAFE spiked dramatically twice during the past 20 years. The first period included the stock-market crash of 1987; the second when large-cap stocks were soaring to precarious levels in the late 1990s and the subsequent bear market. In the past couple of years, the U.S. stock market has reacted twice to short-term market disruptions in emerging markets, including its swoon early this year when China's market fell 10% in a single day.

Problems in the United States are causing similar effects overseas. Markets around the globe, including Japan's, were affected recently by worries about the U.S. subprime crisis and its ripple effects stateside. Mark Headley, manager of Matthews Pacific Tiger MAPTX, told us recently that he worries most about a U.S. recession and the effect it would have on Asian markets.

Now that economies are more interconnected than ever, investors should expect stock markets around the world to move increasingly in step with one another.PAGEBREAK

Foreign or Domestic: Who Can Tell?Further upsetting the idea of diversification is how global many companies have become. Recent research from Standard & Poor's estimates that nearly 45% of the S&P 500's underlying revenue comes from outside the United States. Morningstar analyst Michael Breen found a similar trend in the MSCI EAFE; many foreign firms earn a big share of their profits from outside their home market.

Companies in global industries such as oil, health care, and consumer staples get an especially big portion of their revenues from foreign sources, no matter where they're headquartered. The largest holding in the S&P 500 is ExxonMobil XOM, while British Petroleum BP grabs the same position in EAFE. Both oil companies generate about 30% of their revenue in the United States and the remainder around the globe. Nearly all major oil firms have similarly global profiles--regardless of domicile or which index they call home. The story is the same with big drug makers. GlaxoSmithKline GSK, Roche RHHBY, and Novartis NVS are foreign-domiciled members of EAFE. Johnson & Johnson JNJ, Pfizer PFE, and Abbott Labs ABT are U.S.-based constituents of the S&P 500. All six firms generate close to half their revenues in the United States and the remainder around the globe. Is it accurate to classify any of these companies as foreign or domestic based on their home country?

Similar trends are apparent even among emerging-markets and smaller-cap stocks. Petrobras of Brazil PBR, for example, is certainly a global oil firm. Russian oil firm Lukoil LUKOY even advertised its name during the baseball playoffs at the Philadelphia Phillies' Citizen Bank Park. Several small industrial European firms--such as Vossloh, a maker of rail-track fasteners and other rail components--benefit from China's infrastructure spending.

This corporate globalization makes diversification difficult. It's hard to figure out just how much foreign exposure an investor's portfolio has, even when it's composed primarily of funds classified as "domestic" or "U.S.-focused." On the other side, some foreign funds are certainly giving investors exposure to the U.S. economy.

It Still Pays to TravelIf correlations between markets are high and companies more global, why bother with investing in international markets?

First, even though we've seen correlations move higher in the past 20 years, global markets do not move in lockstep. In fact, in the past two years, correlations have come down a bit, as foreign-market returns have benefited from the weakening U.S. dollar. Also, exposure to different currencies provides diversification benefits--something that could continue to be a near- to medium-term benefit considering the United States' trade and current account deficits. That's certainly been the case recently. While the typical U.S. large-blend fund returned 11% over the past five years, for instance, the average foreign large-blend fund is up 17%.

Moreover, there still are companies that aren't influenced by the global economy as much as by their own local markets. In particular, foreign real estate stocks have been the subject of much attention, specifically for their diversification advantages. And some markets, like Japan's, march largely to the beat of their own drummers. PAGEBREAK

Second, globalization has created great investment opportunities on foreign soil. True, more U.S.-focused funds have increased their investment in foreign holdings, but they still tend to limit how much they can buy. There are enough companies domiciled outside the United States that deserve consideration to warrant a heftier exposure. Portfolio managers with whom we speak often highlight these companies, which they believe are among the best-managed in the world within any given industry. To exclude such stocks is a big opportunity cost for U.S. investors.

Along similar lines, managers often find the most-compelling valuation opportunities outside U.S. borders. When Tweedy, Browne first ventured overseas years ago, it was because some European pharmaceuticals companies and consumer-staples firms were trading at ample discounts to their U.S. counterparts, even though they offered similar growth characteristics. More recently, portfolio managers have pointed out comparatively cheap stocks in Japan, Korea, and other parts of Asia.

And then there's growth. It's been years since the U.S. economy sustained a real GDP growth rate much higher than 3%, and it's unlikely it will again considering its post-industrial makeup and the Federal Reserve's attitudes toward inflation. The same holds true for other developed economies, such as the United Kingdom's and most of those that make up EMU. But there is still growth opportunity in the world. The most talked about, of course, is China's. Plenty of stocks around the world are benefiting from the country's infrastructure spending and need for natural resources. Growth in other countries, such as Poland, India, Spain, and Ireland, have also outpaced the United States'.

The third-and our favorite-reason why investing in foreign stocks is important today is that's where you'll find some great investors who don't manage U.S.-focused portfolios. The fluid state of global opportunities calls for managers who are smart and flexible. As we do when we recommend U.S. funds and portfolio managers, we like international managers with sensible strategies, adequate resources, and strong long-term performance records.

Several managers fit the bill, including Rudolph Raid-Younes and Richard Pell of Julius Baer International Equity BJBIX, Mark Yockey of Artisan's international funds, and Hakan Castegren of Harbor International HAINX. We're also enamored with Oppenheimer's international group. Another favorite, Causeway, offers just two funds-one a broad international fund, the other an emerging-markets choice.

Words of CautionOver the past several years, overseas markets have generally outdone U.S. markets-in part because of the weakening dollar. Over any period, that will happen; over other periods, the reverse will be true. What's particularly notable at this juncture, however, is just how big returns have been in absolute terms. Consider the MSCI EAFE Index is up an annualized 19.61% over the past five years and the MSCI Emerging Markets Index has gained 29.50%.

That said, it's clear that international investments deserve a significant place in long-term investors' portfolios. Think about such vehicles the same way as you would domestic ones. International stocks should help diversify your clients' portfolios, but there are more-compelling reasons to go overseas.